Financial Markets and Intermediaries
Fundamentals of Real Estate - Lecture 1 (January 16, 2024) / Corporate Finance - Class 3 (September 2, 2025)
I. Key Concepts in Finance
A. Investment Decisions (Capital Budgeting)
Definition: Decisions regarding what assets a firm should invest in.
Tangible Assets: Physical assets that can be touched and seen.
Example: Southwest Airlines purchasing new planes.
Intangible Assets: Non-physical assets that have value due to their rights or claims.
Example: GlaxoSmithKline's expenditures on Research & Development (R&D).
B. Financing Decisions
Definition: Decisions on the sources and amounts of financing a firm uses.
Capital Structure: The specific mix of long-term debt and equity financing a firm uses to finance its operations and growth.
C. Interplay of Investment and Financing Decisions
Firm Structure: The firm acts as a central entity, making investment decisions (capital budgeting) to acquire assets, and financing decisions to raise funds through debt and equity.
D. Types of Assets
Real Assets: Assets used to produce goods and services.
Examples: factories, equipment, land, intellectual property.
Financial Assets: Financial claims to the income generated by the firm’s real assets.
Examples: stocks and bonds.
E. How Businesses are Organized
Sole Proprietorship
Ownership: The manager or an individual.
Manager/Owner Separation: No.
Owner's Liability: Unlimited (personal assets are at risk).
Taxation: No separate taxation for owner and business (personal tax on profits).
Partnership
Ownership: Partners.
Manager/Owner Separation: No.
Owner's Liability: Unlimited (personal assets are at risk).
Taxation: No separate taxation for owners and business (personal tax on profits).
Corporation
Ownership: Stockholders.
Manager/Owner Separation: Usually (managers are typically distinct from the broad base of shareholders).
Owner's Liability: Limited (shareholders' liability is limited to their investment in the stock).
Taxation: Yes, separate taxation for owner and business (corporate tax on profits, and then personal tax on dividends received by shareholders – often referred to as double taxation).
Types of Corporations:
Closely Held Corporations:
Ownership: A small group of investors, often family members or a few individuals.
Trading: Stock is not publicly traded on exchanges.
Control: Owners typically have direct control over management and operations.
Examples: Many small family businesses or startups.
Publicly Held Corporations:
Ownership: Shares are owned by a large number of investors and are publicly traded.
Trading: Stock is bought and sold on organized financial exchanges (e.g., NYSE, NASDAQ).
Control: Management is typically separate from the broad base of shareholders, and control is diffused among many investors.
Examples: General Electric, Apple, Microsoft.
F. Conflicts of Interest (Agency Costs)
Stockholder-Manager Conflicts (Agency Costs)
Shareholders' Preference: Higher dividends, focus on long-term shareholder wealth.
Managers' Preference: Higher compensation, often focused on short-term performance tied to their rewards.
Issue: This misalignment can lead to managers making decisions that benefit themselves in the short term, rather than maximizing long-term shareholder value.
Stockholder-Bondholder Conflicts
Shareholders' Preference: Receive profits, prefer projects with large payoffs (often implying higher risk).
Bondholders' Preference: Receive fixed interest payments, prefer safer projects with lower risk.
Issue: If projects are successful, shareholders receive the benefits. If projects fail, bondholders often suffer losses as well. This creates a misalignment between risk and return preferences, where shareholders might favor riskier projects because their upside is greater, while bondholders prefer stable, less risky ventures to ensure their fixed payments.
G. Corporate Governance
Definition: A system of rules and procedures, typically overseen by the board of directors, designed to ensure managers act in the best interests of all constituencies (employees, stockholders, customers).
Objective: To ensure the firm focuses on its long-term success and viability by aligning compensation packages to long-term goals.
Elements of Good Corporate Governance:
Legal requirements: Adherence to laws and regulations.
Board of directors: Provides oversight and guidance.
Activist shareholders: Can exert pressure for changes and improved performance.
Takeovers: The threat of a takeover can motivate management to perform better.
Information for investors: Transparent and comprehensive disclosure of company information.
Key implication: Good corporate governance often leads to companies providing more information, aligning management compensation with long-term goals, and does not discourage activist investors or corporate takeovers but rather ensures management is accountable.
H. Opportunity Cost of Capital
Definition: The rate of return that shareholders can obtain by investing on their own in financial markets with comparable risk.
II. The Capital Allocation Process (Chapter 2 Overview)
A. Efficient Capital Flow
In a well-functioning economy, capital flows efficiently from those who supply it to those who need it.
Suppliers of Capital: Individuals and institutions with excess funds. This includes individuals saving for retirement, investing for future purchases, or holding surplus cash, and institutions such as pension funds, insurance companies, and mutual funds.
B. Demanders of Capital
Definition: Individuals, businesses, and governments that need to raise funds to finance their spending or investment needs.
Examples: Businesses seeking to expand operations, individuals buying homes, or governments funding public projects.
C. Financial Intermediaries
Definition: Institutions that facilitate the flow of capital by bringing suppliers and demanders together.
Role: Financial intermediaries play a crucial role in the capital allocation process by:
Reducing Transaction Costs: They lower the cost of matching borrowers and lenders.
Providing Risk Transformation/Diversification: They allow investors to diversify their investments and transform risky individual assets into less risky portfolios.
Offering Liquidity: They provide a means for investors to quickly convert their investments into cash.
Information Production: They gather and process information about borrowers, reducing information asymmetry.
Examples: Commercial banks, investment banks, insurance companies, and mutual funds.
D. Financial Markets
Definition: Arenas where financial assets are bought and sold, facilitating the transfer of capital between suppliers and demanders.
Types of Financial Markets by Maturity:
Money Market: Market for short-term debt instruments (maturity less than one year).
Examples: Treasury bills, commercial paper, certificates of deposit.
Purpose: Primarily used for short-term borrowing and lending by corporations and governments.
Capital Market: Market for long-term debt and equity instruments (maturity greater than one year or no maturity).
Examples: Stocks, bonds (corporate and government), mortgages.
Purpose: Used for long-term financing and investment.
Types of Financial Markets by Issuance Stage:
Primary Market: Market in which new securities are originally sold to investors.
Process: Firms raise capital by issuing new stocks or bonds directly to investors (e.g., Initial Public Offerings (IPOs) or seasoned equity offerings).
Key characteristic: The issuing company receives the proceeds from the sale.
Secondary Market: Market in which previously issued securities are traded among investors.
Process: Investors buy and sell existing securities from other investors.
Key characteristic: The issuing company does not directly receive any funds from sales on the secondary market. It provides liquidity for investors.
Examples: NYSE, NASDAQ.
Importance of Secondary Markets:
Provide liquidity for investors, making it easier to sell their securities.
Help establish the market price (fair value) for securities, which is crucial for firms when they issue new securities in the primary market.